Power Struggles

In a world where everything is becoming increasingly connected, it is no longer feasible to look at any transaction from just one angle. Especially with the release of new accounting standards that place more emphasis on legal and governance frameworks – finance, tax, credit modelling, risk, legal, regulatory and governance teams have no choice but to speak to each other and ensure that all aspects of a single transaction have been considered. This is particularly important in a banking world where banks are constantly on the lookout to maximise returns and protecting their investments, without crossing the line into controlling the underlying company. Where does one draw the line between investing and control?

In terms of the guidance in International Financial Reporting Standard 10 (“IFRS 10”) Consolidation, there are three key elements to any control assessment:

  1. Power
  2. Exposure to variable returns; and
  3. The ability to use that power to influence variable returns.

In assessing the above criteria, control assessments can be quite tricky when entities use complex structures to set up transactions to achieve specific objectives e.g. Tax benefits or to set up Black Economic Empowerment (BEE) transactions that are quite common within the South African context. As part of this assessment, consideration must be given to the underlying legal agreements. If the legal agreements are not aligned to the objectives of the transaction, the result can get quite messy and have unintended consequences. To navigate these murky waters with ease and clarity, it’s important to always consider “substance over form”.

To help with such an assessment, we recommend the following tips:

  • Proactive-ness: First prize is to always consult with the relevant stakeholders (especially accounting, tax and legal) before initiating a transaction to ensure that any hot spots are highlighted, considered, discussed and addressed upfront.
  • Processes: Another way to manage such a situation, would be to relook at the existing processes around when such a transaction is initiated and rebuild, update and simplify the processes. Over time, there are constant changes in what management may need to comply with and consider when making investments. It’s becoming increasingly important for management to keep their finger on the pulse, understand what the relevant requirements are in an ever changing landscape of accounting, tax, legal and regulatory – and ensure that all of these requirements are built into the surrounding processes.
  • Paperwork: Often times transactions are structured at a point in time, and with employee turnover, the people involved in setting up a transaction may not be around to share their knowledge or insights regarding the intention and objective that was originally discussed. What’s helpful is to take a step back and understand why something was done a certain way. To avoid having to explain the same concept over and over again, write it down. Put it down on paper, explain it, and sign it off. This saves time and provides an audit trail which makes life easier on both the auditors and management.

But what happens when legal agreements have already been drafted, and it’s unclear what the intention was at the outset of the transaction? What if the legal agreements don’t stack up with management’s intention or objective of a specific transaction?

We recommend going back to basics of the underlying transaction and unpacking the answer to the most fundamental question in a control assessment: “What are the relevant activities?”

  1. Which are the most significant relevant activities that affect a company's returns?
  2. Who has the power to direct or make decisions around those activities?
  3. What happens when entities are set up so that their activities are predetermined?

If something goes wrong, for example a pandemic virus spreads globally and results in a significant decrease in a company’s investment portfolio which has a detrimental impact on the company’s performance, management would need to assess control based on who would have the current ability to make decisions that affect this entity’s performance going forward?

Factors that need to be considered in answering this question include (but are not limited to) voting rights, control over cash flows, interpretation of the interplay between legal agreements and accounting requirements etc. When applying interpretations of the accounting requirements, companies need to ensure that all interpretations are applied consistently.For instance, the definition of default as defined in the underlying legal agreements (which sometimes references the solvency/liquidity requirements as per the Companies Act) should be aligned to how a company has defined what default looks like for them in terms of IFRS 9Financial Instruments.

Ultimately, it may cost companies some time and expertise to ensure the accounting process of a transaction lines up with the intention, but as a wise doctor once told me, a stitch in time saves nine.

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