The Hindu Business Line : Consolidation of promoter-driven companies

International Financial Reporting Standards (IFRS) is fast becoming the governing language of global financial reporting. India too will converge to IFRS in 2011. Contrary to popular belief, most standards have an impact on the financial statements of corporates, even though the scale and significance may vary.

One such accounting guidance that may have a major impact will be SIC-12 (Standing Interpretations Committee) which deals with consolidation of Special Purpose Entities (SPE). The conversion impact will be most felt by promoter-driven Indian companies, which historically have used legal loopholes to keep certain controlled entities out of the consolidation chain.

Further, unlisted companies which have never prepared consolidated financial statements will feel the pinch. The question being raised and requiring clarification is the case of auto ancillaries, which typically are extensions of the main manufacturer and have multiple types of arrangements.

An SPE is an entity created to accomplish a specific objective (for example, lease, research activities, investment vehicles, etc.), wherein the sponsors, having no majority voting rights, often impose strict/permanent limits on the decision-making powers of the management over their operations. An SPE can be set up in various forms, including a corporation, trust, partnership, etc. Most importantly, an SPE can even be an unincorporated entity.

Existence of control

Both Indian GAAP and IFRS advocate the preparation of consolidated financial statements to be based on the existence of control/significant influence as the case may be.

The definition of control under Indian GAAP is based on majority voting rights, whereas under IFRS it is based on substance rather than form. Under IFRS, an entity can obtain control over another entity without holding more than one-half of the voting power of the other entity and even without having control of the composition of the board of directors, provided the existence of control can be demonstrated. So, it appears that even a zero shareholding (SPE) may be consolidated.

That said, SIC-12 states that an SPE shall be consolidated when the substance of the relationship between an entity and the SPE indicates that the SPE is controlled by that entity. Even though one needs to evaluate control of an SPE under the consolidation standard of IAS 27, the guidance of SIC-12 provides additional factors which need to be considered in determining whether there is control on the SPE or not and these are based on the substance of the transactions rather than their form:

Whether the activities of the SPE are being conducted on behalf of the entity, which directly or indirectly created the SPE, according to its specific business needs;

Whether the entity has the decision-making powers to obtain the majority of the benefits of the activities of the SPE;

Whether the entity has rights to obtain the majority of the benefits of the SPE and is exposed to risks incident to the activities of the SPE; or

Whether the entity retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.

SIC-12 states that, if one or more of these circumstances exist, the financial statements of the SPE is required to be consolidated as if the SPE is a subsidiary within the group; and the normal consolidation procedures that would apply for consolidating a subsidiary would then be applicable, which means elimination of transactions, line by line consolidation, elimination of profits/losses etc.

An illustration

Let us consider an example: The promoters of A Ltd, a listed company engaged in automobile manufacturing, have another company X Ltd, which is not within the consolidation chain of A Ltd as per Indian GAAP because all shares are directly held by the promoters in their personal capacity.

The promoters wanted to diversify into manufacturing certain parts of the automobile, which they thought they would do in X Ltd. Accordingly, X Ltd took a huge loan from a bank against the guarantee of A Ltd.

After taking the loan, X Ltd started construction of the plant and midway the automobile market collapsed and there is no visibility in the future. Further, X Ltd does not have any funds to repay the huge loans and the risks of these loans lie with A Ltd.

Accordingly, A Ltd will treat X Ltd as an SPE and consolidate the entity.

Wide scope

Therefore, it would be correct to believe the scope of SIC-12 to be broad. As of now, promoter group companies outside the consolidation chain are considered as parking slots. Various transactions which may be questioned for its genuineness and ethical substance, or an expense which would have been generally questioned by regulators, are routed through such companies.

Preparing consolidated financial statements based on IFRS would result in most of such companies being consolidated. Consolidating the financial statements of such companies will in turn impact consolidated sales, profit margins, various ratios, including debt equity ratios, to name a few.

From an investor standpoint, SIC-12 would result into disclosing the true net worth of these companies and hence the true valuations. Several companies use their promoter companies during turbulent times to show a sound financial position. However, with IFRS, all these transactions will be eliminated. Indian companies need to be prepared for handling the complexities of SIC-12.

(The authors are with a member firm of Ernst & Young Global.)

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