a plain vanilla foreign exchange or interest rate swap should be considered a creator or
absorber of variable returns. It is our view that an exposure to variable returns generally
absorbs the variability created by the investee’s assets, liabilities or other contracts, and
the risks the investee was designed to pass along to its investors. Therefore, if a
derivative is entered into to reduce the variability of a structured entity’s cash flows
(such as might arise from movements in foreign currency or interest rates), it is not
intended to absorb the cash flows of the entity. Instead, the derivative is entered into to
align the cash flows of the assets of the structured entity with those of the investors and
414 Chapter
6
so reduce the risks to which the investors in the structured entity are exposed.
Accordingly, the counterparty would not have an exposure to a variable return.
Meanwhile, a counterparty to a foreign exchange or interest rate swap typically has a senior
claim on any cash flows due under the swap relative to any note holders. Consequently, it
is unlikely to be exposed to the credit risk of the assets held by the structured entity, or else
that risk will be deemed to be insignificant (i.e. losses on the assets would need to be so large
that there would be insufficient funds in the structured entity to settle the derivatives).
However, if payments on a swap were subordinate to the rights of note holders, or
contractually referenced to the performance of the underlying assets in the structured
entity, the counterparty is exposed to the risk associated with the performance of the
underlying assets (i.e. the risk that the structured entity may be unable to fulfil its obligations
under the swap). In that case, if the swap counterparty had power over the structured entity
because it has the ability to manage its assets, it is likely that it would be deemed to have
the ability to affect its variable returns and so would control the structured entity.
The above principles are illustrated in Example 6.21 below.
Example 6.21: Structured entity that enters into foreign currency and interest
rate swaps
Sale of USD
bonds
Issues Euro
Notes
Bank
Structured entity
Investors
FX and interest
rate swaps
USD bonds
A bank designs a structured entity to meet the requirements of European investors, who wish to be exposed
to US corporate bonds without the foreign exchange risk. The structured entity buys dollar-denominated debt
securities through the bank, issues Euro-denominated notes and hedges the cash flow differences through a
series of swaps entered into with the bank. Subsequently, the structured entity collects and pays the resultant
cash flows. The bonds will be held by the structured entity until maturity and cannot be substituted. The bank
manages the assets, including in the event of their default and earns a fixed fee for its services. The right to
receive the fee ranks more senior than the notes.
Most of the activities of the structured entity are predetermined. It is possible that the relevant activity is the
management of the assets in the event of default as discussed at 4.1.4 above. If this is the case, power is held
by the bank, since it has the existing rights that give it the current ability to direct this activity. In evaluating
the bank’s exposure to variable returns from its involvement with the structured entity:
• the foreign currency and interest rate risks were not risks that the structured entity was designed to be
exposed to or to pass on to the bank;
• the bank’s exposure to movements in foreign exchange and interest rate risks is not affected by its power
over the relevant activity;
• the fixed fee that the bank earns is not considered a variable return as its payment is unlikely to be
affected by the credit risk of the bonds; and
• the bank’s exposure to potential credit risk on its derivatives is considered insignificant, as that risk
would only arise if losses on the bonds were so large that there were insufficient funds in the structured
entity to settle the derivatives.
In conclusion, even if the bank has power by virtue of managing the defaults (i.e. the relevant activity), the bank has
no exposure to variable returns, and thus does not control the structured entity and so would not consolidate it.
Consolidated financial statements 415
5.3.2
Total return swaps
The principles discussed at 5.3.1 above are also relevant where a structured entity enters
into a total return swap, since the swap creates an equal, but opposite risk to each party,
as illustrated in Example 6.22 below.
Example 6.22: Structured entity that enters into a total return swap
Total return
Issues fixed
swap
rate notes
Bank
Structured entity
Investors
Equity securities
A structured entity acquires a portfolio of equity securities from the market, issues fixed rate notes to investors
and hedges the mismatch in cash flows between the equity securities and the notes through entering into a
total return swap with a bank. The choice of equity securities that make up the portfolio is pre-agreed by the
bank and the note investors. However, the bank also has substitution rights over the equity securities held by
the structured entity within certain parameters. The terms of this swap are that the structured entity pays the
bank any increase in value of the securities and any dividends received from them, while the bank pays the
structured entity any decline in the value of the securities and interest at a fixed rate.
The structured entity was designed to give equity risk to the bank while the note holders earn a fixed rate of
interest. The bank’s substitution rights over the equity securities is likely the relevant activity, because it may
significantly affect the structured entity’s returns. Therefore, the bank has power. The bank also has an
exposure to variable returns since it absorbs the equity risk. Since it has the ability to use its power to affect
its returns from the total return swap, all three criteria for control are met and the bank would consolidate the
structured entity.
5.4
Exposures to variable returns not directly received from an
investee
When identifying an exposure to variable returns, an investor must include all variable
returns resulting from its investment including not only those directly received from the
investee but also returns generated as a result of the investment that are not available to
other interest holders. [IFRS 10.B57].
Generally, the focus is on the variable returns that are generated by the investee.
However, depending on the purpose and design of the arrangements and the investee,
when the investor receives variable returns that are not generated by the investee, but
stem from involvement with the investee, these variable returns are also considered.
Examples of such variable returns include using assets in combination with the assets of
the investee, such as combining operating functions to achieve economies of scale, cost
savings, sourcing scare products, gaining access to proprietary knowled
ge or limiting
some operations or assets, to enhance the value of the investor’s other assets.
[IFRS 10.B57(c)].
5.5
Exposure to variable returns in bankruptcy filings
As discussed at 4.3.2.A above, evaluating whether an investor has control when its
investee files for bankruptcy requires the exercise of judgement based on the facts and
circumstances. Part of the assessment includes an evaluation of whether the investor
416 Chapter
6
has an exposure to variable returns from the investee once the investee files for
bankruptcy. For example, based on the requirements for the particular type of
bankruptcy in the relevant jurisdiction:
• Is the investee restricted from paying dividends to the investors upon filing for
bankruptcy?
• Are the investors exposed to a variable return through their interests in the investee,
notwithstanding the bankruptcy (e.g. do shares in the investee retain any value)?
• Do the investors have a loan receivable, or other financial interest in the investee,
that is expected to provide a return (or is the loan worthless)?
• Do the investors have access to other synergies from the investee?
For an investor to have control, it must also have power (as discussed at 4.3.2.A above)
and the ability to use its power over the investee to affect the amount of the investor’s
returns (see 6 below).
5.6
Interaction of IFRS 10 with the derecognition requirements in
IFRS 9
In evaluating whether an entity has an exposure to the variable returns of a structured
entity, it is also necessary to consider the interaction with the derecognition
requirements set out in IFRS 9 (see Chapter 48). Specifically, it is relevant to consider
the impact of whether or not the transfer criteria have been satisfied by the transferor
on whether a transferor has exposure to variable returns arising from its involvement
with a structured entity. The following example will help illustrate this issue.
Example 6.23: Structured entity that enters into a total return swap with the
transferor
Assume the same facts as in Example 6.22 at 5.3.2 above, except that the bank originally sold the equity
securities to the structured entity (rather than the structured entity acquired the equity securities from the market).
As the bank has, through the total return swap, retained substantially all of the risks and rewards of ownership
of the securities, it would not derecognise them. Consequently, the structured entity would not recognise the
securities but, instead recognises a loan to the bank, collateralised by the securities. As the bank has not
derecognised the securities, it has no variable return from its involvement with the structured entity. Hence,
it does not have control of the structured entity and would not consolidate it. The investors have no power
over the structured entity, so none of the investors would consolidate it either.
5.7 Reputational
risk
The term ‘reputational risk’ often refers to the risk that failure of an entity could damage
the reputation of an investor or sponsor. To protect its reputation, the investor or sponsor
might be compelled to provide support to the failing entity, even though it has no legal or
contractual obligation to do so. During the financial crisis, some financial institutions
stepped in and provided financing for securitisation vehicles that they sponsored, and in
some cases took control of these vehicles. The IASB concluded that reputational risk is
not an indicator of power in its own right, but may increase an investor’s incentive to
secure rights that give the investor power over an investee. Accordingly, reputational risk
alone would not be regarded as a source of variable returns and so would not require a
bank to consolidate a structured entity that it sponsors. [IFRS 10.BC37-BC39].
Consolidated financial statements 417
6
LINK BETWEEN POWER AND RETURNS: PRINCIPAL-
AGENCY SITUATIONS
The third criterion for having control is that the investor must have the ability to use its
power over the investee to affect the amount of the investor’s returns. [IFRS 10.7]. An
investor controls an investee if the investor not only has power over the investee and
exposure or rights to variable returns from its involvement with the investee, but also
has the ability to use its power to affect the investor’s returns from its involvement with
the investee. [IFRS 10.17].
Thus, an investor with decision-making rights shall determine whether it is a principal
or an agent. An investor that is an agent in accordance with paragraphs B58-B72 of
IFRS 10 does not control an investee when it exercises decision-making rights delegated
to it. [IFRS 10.18]. This is discussed further at 6.1 below.
In January 2015, the Interpretations Committee noted that a fund manager that
concludes that it is an agent in accordance with IFRS 10 should then assess whether
it has significant influence in accordance with the guidance in IAS 28. 7 See
Chapter 11 at 4.
The link between power over an investee and exposure to variable returns from
involvement with the investee is essential to having control. An investor that has power
over an investee, but cannot benefit from that power, does not control that investee. An
investor that has an exposure to a variable return from an investee, but cannot use its
power to direct the activities that most significantly affect the investee’s returns, does
not control that investee. This is illustrated in Example 6.24 below.
Example 6.24: Link between power and returns is essential for control
A structured entity is created and financed by debt instruments held by a senior lender and a
subordinated lender and a minimal equity investment from the sponsor. The subordinated lender
transferred receivables to the structured entity. Managing the receivables in default is the only activity
of the structured entity that causes its returns to vary, and this power has been given to the subordinated
lender by contract. The subordinated loan is designed to absorb the first losses and to receive any
residual return from the structured entity. The senior lender has exposure to variable returns due to the
credit risk of the structured entity.
When analysing which investor, if any, has control the first step is to identify the relevant activities. In this
example, managing the receivables in default is the only activity of the structured entity that causes its returns
to vary. Therefore, it would be the relevant activity. The next step is to determine which investor, if any, has
the current ability to direct that relevant activity. In this example, the subordinated lender has the power that
it was granted by contract. The subordinated lender is exposed to variable returns from its involvement with
the structured entity through its subordinated debt. The subordinated lender has the ability to affect those
returns through its power to manage the receivables in default. Since all three elements of control are present,
the subordinated lender has control over the structured entity. This evaluation is made in the context of
understanding the structured entity’s purpose and design.
While the senior lender’s exposure to variable returns is aff
ected by the structured entity’s activities, the
senior lender has no power to direct those activities. Thus, the senior lender does not control the structured
entity, because it is missing two of the elements of control.
6.1
Delegated power: principals and agents
When decision-making rights have been delegated or are being held for the benefit of
others, it is necessary to assess whether the decision-maker is a principal or an agent to
418 Chapter
6
determine whether it has control. This is because if that decision-maker has been
delegated rights that give the decision-maker power, it must be assessed whether those
rights give the decision-maker power for its own benefit, or merely power for the
benefit of others. An agent is a party primarily engaged to act on behalf of another party
or parties (the principal(s)), and therefore does not control the investee when it
exercises its decision-making powers. [IFRS 10.B58]. As an agent does not control the
investee, it does not consolidate the investee. [IFRS 10.18].
While principal-agency situations often occur in the asset management and banking
industries, they are not limited to those industries. Entities in the construction, real
estate and extractive industries also frequently delegate powers when carrying out their
business. This is especially common when an investee is set up and one of the investors
(often the lead investor) is delegated powers by the other investors to carry out activities
for the investee. Assessing whether the lead investor is making decisions as a principal,
or simply carrying out the decisions made by all the investors (i.e. acting as an agent)
will be critical to the assessment.
An investor may delegate decision-making authority to an agent on some specific issues
or on all relevant activities, but, ultimately, the investor as principal retains the power.
This is because the investor treats the decision-making rights delegated to its agent as
held by the investor directly. [IFRS 10.B59]. Accordingly, a decision-maker that is not an
agent is a principal. However, it should be noted that:
• a decision-maker is not an agent simply because others benefit from the decisions
that it makes; [IFRS 10.B58] and
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 83