Control and structured entities

Most subsidiaries are controlled the ordinary way: the parent owns most of the voting shares and elects the board. Some entities, however, are designed so that voting rights are not what determines who directs them. A securitization vehicle that buys a company's receivables, a leasing entity created to own a single building, a research partnership funded by a sponsor or an investment fund run by a manager may have little or no voting equity, and their activities are set largely by contracts drawn up when they were created. Enron's use of such entities to keep debt off its balance sheet in the 1990s led standard setters to write rules that look past voting rights to who really directs the entity and who bears its risks and rewards. This lesson explains those rules.

The IFRS 10 control model

IFRS 10 applies a single control model to all investees. An investor controls an investee when it has all three of these elements: power over the investee; exposure, or rights, to variable returns from its involvement with the investee; and the ability to use its power over the investee to affect the amount of the investor's returns. The assessment is made continuously, and the investor reassesses whether it controls an investee if facts and circumstances indicate that any of the three elements has changed.

Power means existing rights that give the investor the current ability to direct the relevant activities, the activities that significantly affect the investee's returns. For a manufacturing company these are its operating and financing decisions; for a receivables vehicle they may be only the management of defaulted receivables. Rights must be substantive, meaning the holder has the practical ability to exercise them; protective rights, designed to protect the holder's interest without giving power, such as a lender's right to block a sale of assets, do not count. Potential voting rights, such as share options, are considered if they are substantive, for example if they are currently exercisable at a price that is not prohibitive.

Power can also come without a majority of votes. An investor holding a large minority stake when the remaining shares are widely dispersed among many small holders who are unlikely to organize may have de facto control. Contracts may give power, for example a management agreement that lets the investor direct a structured entity's activities. The IFRS 10 guidance also asks how the investee was designed and whether the investor was involved in that design, because involvement in setting up a structured entity often indicates that the investor has power.

Structured entities

IFRS 12 defines a structured entity as one designed so that voting or similar rights are not the dominant factor in deciding who controls it, such as when voting rights relate only to administrative tasks and the relevant activities are directed by contract. Typical features include restricted activities, a narrow and well-defined objective, insufficient equity to finance activities without subordinated support, and financing through multiple contractually linked instruments that create concentrations of credit or other risk (tranches). IFRS 10 applies the same control model to structured entities, but the analysis focuses on contracts, design and exposure to variability rather than on votes.

# Who absorbs the variability? Expected losses of a receivables vehicle (illustrative)
import statistics
scenarios = [(0.60, 0), (0.25, 300_000), (0.10, 900_000), (0.05, 2_400_000)]   # (probability, credit losses)
assets = 20_000_000
tranches = [("Larkspur subordinated note", 1_600_000), ("Bank senior notes", 18_400_000)]
expected = sum(p * l for p, l in scenarios)
print(f"Expected credit losses on {assets:,.0f} of receivables: {expected:,.0f}")
absorbed = {n: 0.0 for n, _ in tranches}
for p, loss in scenarios:
    remaining = loss
    for n, size in tranches:                      # first loss goes to the subordinated note
        take = min(remaining, size); absorbed[n] += p * take; remaining -= take
for n, v in absorbed.items():
    print(f"{n:<28} expected loss absorbed {v:>10,.0f}  ({v / expected:.0%})")

Expected credit losses on 20,000,000 of receivables: 285,000
Larkspur subordinated note   expected loss absorbed    245,000  (86%)
Bank senior notes            expected loss absorbed     40,000  (14%)

The expected-loss program shows why the first-loss position matters. Across the scenarios, expected credit losses are $285,000, and Larkspur's $1,600,000 subordinated note absorbs about 86 per cent of them, because it takes every loss up to $1,600,000 before the banks lose anything. Under current standards the analysis is qualitative, focusing on power and the potential significance of exposure, but quantitative work like this supports the judgement that the exposure is significant.

Principals and agents

A decision maker with power may be acting as an agent for others rather than for itself. A fund manager that directs a fund's investments under a contract with investors uses its power on their behalf. The standards look at the scope of the decision maker's authority, the rights held by others (especially rights to remove the decision maker without cause), its remuneration and whether it is commensurate with the services provided and on market terms, and its exposure to variability from other interests it holds. A manager with a market-rate fee and a small investment, who can be removed by a simple majority of independent investors, is usually an agent and does not consolidate the fund.

# Assessing control of four entities (illustrative assessments)
entities = {
    "Receivables trust": {"vote_pct": 0.00, "power_by_contract": True,  "variable_returns": "subordinated note, 8% of assets", "agent": False},
    "Fjord supplier":    {"vote_pct": 0.00, "power_by_contract": False, "variable_returns": "guarantees supplier debt",        "agent": False},
    "Sensor fund":       {"vote_pct": 0.02, "power_by_contract": True,  "variable_returns": "1% fee, 2% units",                "agent": True},
    "Prairie Labs":      {"vote_pct": 0.45, "power_by_contract": False, "variable_returns": "45% of dividends",                "agent": False},
}
dispersed_others = {"Prairie Labs": True}
for name, e in entities.items():
    power = e["vote_pct"] > 0.5 or e["power_by_contract"] or (e["vote_pct"] >= 0.40 and dispersed_others.get(name, False))
    controls = power and bool(e["variable_returns"]) and not e["agent"]
    reason = "agent, not principal" if e["agent"] else ("no power over relevant activities" if not power else "power + returns + link")
    print(f"{name:<18} power={str(power):<5} consolidate={str(controls):<5} ({reason})")

Receivables trust  power=True  consolidate=True  (power + returns + link)
Fjord supplier     power=False consolidate=False (no power over relevant activities)
Sensor fund        power=True  consolidate=False (agent, not principal)
Prairie Labs       power=True  consolidate=True  (power + returns + link)

The program applies a simplified version of the analysis. Larkspur consolidates the receivables trust (power by contract plus first-loss exposure) and Prairie Labs, where its 45 per cent stake gives de facto control because the other shareholders are widely dispersed. It does not consolidate the sensor fund, where it acts as an agent, or the Fjord supplier, where a guarantee gives it exposure but no power over the supplier's activities. Real assessments involve more facts and judgement, and IFRS and US GAAP can reach different answers on de facto control.

US GAAP generally does not recognize de facto control under the voting interest model: a large minority holding without majority voting rights or contractual control usually leads to the equity method, not consolidation. This is one of the clearest practical differences between IFRS 10 and ASC 810.

Investment entities

IFRS 10 contains an exception for investment entities, such as venture capital and private equity funds, that obtain funds from investors to provide investment management services, commit to investing solely for capital appreciation or investment income, and measure and evaluate substantially all investments on a fair value basis. An investment entity does not consolidate its controlled investees; it measures them at fair value through profit or loss. The exception does not carry up to a parent that is not itself an investment entity, which must consolidate all entities it controls, including those held through an investment entity subsidiary.

Private company and other options

Canadian private enterprises applying ASPE define a subsidiary by reference to the continuing power to determine strategic operating, investing and financing policies without the co-operation of others (Section 1591), and the Handbook also includes guidance on variable interest entities. Because ASPE lets a private enterprise account for subsidiaries by the equity or cost method instead of consolidating, the practical consequences of a control conclusion are smaller than for IFRS reporters; readers should check the current Handbook for how the policy choice applies to particular arrangements.

Why it matters

Whether a structured entity is consolidated changes reported assets, debt and ratios, sometimes dramatically. Securitizations kept off the balance sheet before 2008 hid exposures that returned to banks' balance sheets during the financial crisis. Current rules bring most sponsor-designed vehicles onto the sponsor's balance sheet, and disclosures about unconsolidated structured entities and VIEs, including the maximum exposure to loss, tell users about risks that remain off balance sheet.

Disclosures about involvement with other entities

IFRS 12 requires disclosure of the significant judgements and assumptions made in deciding whether the entity controls, jointly controls or significantly influences another entity, the interests of NCI in group activities, restrictions on using group assets, and the nature of and risks associated with interests in consolidated and unconsolidated structured entities, including the maximum exposure to loss and any financial support provided without a contractual obligation. These disclosures let users see the judgements behind the consolidation boundary.