Evaluating not-for-profit entities for consolidation under Ind AS 110 : Focus beyond financial returns

Evaluating not-for-profit entities for consolidation under Ind AS 110 : Focus beyond financial returns

Many Indian companies have set-up not-for-profit entities (NPEs) to carry out corporate social responsibility (CSR) activities in compliance with the requirements of Section 135 of the Companies Act, 2013 (as amended) (‘the Act’) or other welfare measures for the society in the area where the Company is operating. These NPEs are generally structured as a charitable trust under the Indian Trusts Act, 1882, section 8 company incorporate under the Act, or a society registered under the Societies Registration Act, 1860. The Company or the Sponsoring Entity (SE) (hereinafter referred to as ‘the Company’) also makes initial contribution as well as ongoing contribution to the NPE to carry out CSR/ welfare activities. In many cases, the Company continues to be the sole contributor to the NPE activities; in other cases, the NPE may also be receiving contributions from other entities.

Salient features of NPEs

Given below are salient features of NPE which may be relevant for evaluating control under Ind AS 110 Consolidated Financial Statements:

1 Purpose and funding

• The primary purpose of establishing an NPE is to fulfill the Company’s CSR obligations and/ or to carry out other activities for meeting its welfare objective.
• The Company generally contributes funds and provides liquidity support to the NPE, for carrying CSR and/ or welfare activities.

2 Initial set-up and ownership

• The Company sets up and makes initial contribution to the NPE. It is also the single/ largest shareholder in case of section 8 company. Similarly, the Company will be settlor of the Trust in case of a Charitable Trust.
• The Company is actively involved in deciding design and purpose of the NPE as well as finalizing its governing documents, such as Memorandum of Association (MOA) and Articles of Association (AOA) of section 8 company or Trust Deed of Charitable Trust.
• The CSR Rules under the Act mandate that CSR activities be undertaken either by the Company itself or through a Section 8 company established by the Company. In the case of CSR compliance, this is one key consideration in deciding structure of the NPE.

3 Governance and decision making

• The Company, being sole shareholder or the settlor, has an exclusive right to appoint and remove all or majority board members or trustees of the NPE. Generally, these board members or trustees are key managerial personnel (KMPs) or other senior employees of the Company.
• Key activities of NPE generally include investment of surplus funds, borrowing (if required), and carrying out CSR/ welfare activities as per the governing documents. The decisions related to CSR/ Welfare activities may comprise identifying projects, identifying area to carry out these projects, deciding amount and involving service providers, etc. All these decisions are made by the board of directors/ trustees of the NPE.
• In certain cases, it is stated that the trustees/ board of directors have independent decision making. However, it may be noted that these trustees/ directors have fiduciary responsibility and need to carry out activities as per the framework laid in the governing documents, settlor/ shareholder as well as contributor to the fund.

4 Restrictions on profit distribution

• As per the regulatory and/ or registration framework, NPE is explicitly prohibited from distributing any profits to its members/ shareholders. Nor it can repay capital/ initial contribution to the shareholders/ settlor.
• Any profits or income generated must be applied solely toward promoting its stated objectives. No portion of profits or property may be distributed, directly or indirectly, as dividends, bonuses, or any other form to its members or shareholders.
• However, the above clauses do not restrict NPE from making below payments even if such payments accrue to the members or shareholders:
  • Out-of-pocket expense reimbursements
  • Prudent remuneration for services rendered
  • Reasonable interest on loans provided to the NPE
  • Reasonable rent for premises leased to the NPE
• In the event of liquidation, residual assets of the NPE will be transferred to another NPE carrying out similar activities.

Matter under evaluation

Considering the above structure, an issue has often been asked whether the Company needs to treat NPE as its subsidiary and therefore, should it consolidate the NPE under Ind AS 110?

Based on our understanding, this question arises primarily from the fact that the NPE is not allowed to repatriate profit or capital back to the Company. We also understand that there may be certain arguments that the Company does not get any financial return from its involvement with the NPE. Hence, the Company does not meet variable return criterion of control definition under Ind AS 110 and the Company need not consolidate the NPE.

It is to be noted that the Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India (ICAI) had recently considered an issue related to NPE consolidation and it did not agree with the above view that there is no need to consolidate NPE since there is no variable return. In other words, the EAC concluded that, based on facts given, the NPE should be consolidated.

In this article, we analyze NPE consolidation matter under Ind AS 110 and our understanding of the position taken by the EAC. Whilst this article covers various aspects of control evaluation, it may be noted that the major debate on control evaluation relates to ‘variable return’ criterion and, therefore, the article focuses primarily on an evaluation of the said criterion.

Control evaluation of NPE as per Ind AS 110

Ind AS 110 Consolidated Financial Statements provides scope exclusion with regard to post-employment benefit plans or other long-term employee benefit plans to which Ind AS 19, Employee Benefits, applies. Hence, an entity or trust set-up to manage such plans is not considered for control evaluation under Ind AS 110. However, there is no such scope exclusion for NPEs. Hence, companies setting up NPEs or otherwise involved in their activities will need to evaluate them for consolidation under Ind AS 110.

Ind AS 110 establishes a single consolidation model based on the concept of control. Under Ind AS 110, an investor controls an investee and consequently consolidates it when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Given below is an overview of control model under Ind AS 110:

Assessing control

Power

Identify power

Determine which party, if any, has power, that is, the current ability to affect or direct relevant activities. Power arises from the rights which may include:

• Voting rights
• Potential voting rights (e.g., Options or convertible instruments).
• Rights to appoint key personnel
• Decision making rights within a management contract,
• Removal or ‘kickout’ rights

However power does not arise from protective rights.

Return

Assess Return

Assess whether the investor is exposed or has rights to variable returns from its involvement with the investee. Returns can be positive, negative or both.

Examples of returns include:

• Dividends
• Remunerations
• Economies of scale, cost savings, scarce product, proprietary knowledge, synergies, or other returns that are not available to other interest holders.

Linkage

Evaluate linkage

Evaluate whether the investor has the ability to use its power to affect the investor’s returns from its involvement with the investee applicable. Determine whether the investor is a principal or an agent considering

• Scope of its authority
• Rights held by other parties
• Remuneration
• Exposure to variability from other interests

Understand purpose and design of investee
Continuous assessment

For evaluating control over NPEs, application of the above criteria, particularly criteria related to variable return, can be challenging due to the unique structure of NPEs. Key aspects of control evaluation with specific focus on challenging part are described below.

1. Understand purpose and design

When assessing control of the NPE, the Company considers purpose and design of the NPE in order to identify its relevant activities, how decisions about the relevant activities are made, who has the current ability to direct those activities and who receives returns from those activities. Understanding the purpose and design of an investee is therefore critical when identifying who has control. Understanding the purpose and design of the investee helps to determine:

• To what risks was the NPE designed to be exposed, and what are the risks it was designed to pass on to the parties with which it is involved?
• What are the relevant activities?
• How are decisions about the relevant activities made?
• Who has the ability to direct the relevant activities?
• Which parties have exposure to variable returns from the investee?
• How do the relevant activities affect returns?
• Do the parties that have power and have exposure to variable returns have the ability to use that power to affect returns?

In essence, grasping the NPE’s purpose and design reveals the goals of each investor and parties involved, i.e., why they are involved with the investee and what that involvement is.

In the instant case, the primary purpose of establishing NPE is to fulfill the Company’s CSR obligations and/ or to carry out other activities for meeting its welfare objective. The Company sets up and makes initial contribution to the NPE.

It is also the single/ largest shareholder in the case of section 8 company and settlor in case of the Charitable Trust. The Company is actively involved in deciding design and purpose of the NPE as well as finalizing its governing documents. These facts may indicate/ suggest a close relation between the Company’s objective and the NPE activities, including how the NPE plays an important role in achieving the Company objectives.

2. Power

The first criterion to have control relates to power. The power arises from existing rights that give the holder the current ability to direct the relevant activities. Relevant activities are the activities of the investee that significantly affect its returns. The rights that may give an investor power can differ between investees. Examples of rights that, either individually or in combination, can give an investor power include but are not limited to:

• Rights in the form of voting rights (or potential voting rights) of the investee
• Rights to appoint, reassign or remove members of an investee’s key management personnel who have the ability to direct the relevant activities
• Rights to appoint or remove another entity that directs the relevant activities
• Rights to direct the investee to enter into, or veto any changes to, transactions for the benefit of the investor
• Other rights (such as decision-making rights specified in a management contract) that give the holder the ability to direct the relevant activities

Hence, Ind AS 110 gives an inclusive list of rights which either on their own or with other rights can suggest that the Company has power over the NPE. To evaluate this aspect, key questions to be asked are include:

• What are the relevant activities of the NPE?
• How decisions about these activities are made? Who makes those decisions?
• Who has the right to appoint and remove persons responsible for making those decisions?
• Whether the persons responsible for making decision playing role in fiduciary capacity? To whom they have such a fiduciary capacity?
• What are the rights the Company has with regard to relevant activities of the NPE?
• Does the Company directly or indirectly have the ability to direct relevant activities of the NPE?
• Can the Company directly or indirectly decide or influence key elements of the NPE decisions related to CSR/ welfare activities?
• Does the governance framework of the NPE provide the Company with the power over the subsidiary?

Based on our experience, in majority cases, it is clear that the Company has power over the relevant activities including investment of surplus funds, borrowing (if required), and carrying out CSR/ welfare activities as per the governing documents of the NPE. Such power may be arising from factors such as involvement in initial set-up, shareholding, right to appoint/ remove the board or trustees, and/ or directions issued at the time of contribution, etc. If the control is not clear, further evaluation may be needed.

3. Variable returns

As stated above, variable return is one key factor/ challenge with regard to control evaluation over the NPE under Ind AS 110. In the regard, the following key requirements of Ind AS 110 may be noted:

• B55. When assessing whether an investor has control of an investee, the investor determines whether it is exposed, or has rights, to variable returns from its involvement with the investee.
• B56. Variable returns are returns that are not fixed and have the potential to vary as a result of the performance of an investee. Variable returns can be only positive, only negative, or both positive and negative (see paragraph 15). An investor assesses whether returns from an investee are variable and how variable those returns are on the basis of the substance of the arrangement and regardless of the legal form of the returns. For example, an investor can hold a bond with fixed interest payments. The fixed interest payments are variable returns for the purpose of this Ind AS because they are subject to default risk and they expose the investor to the credit risk of the issuer of the bond. The amount of variability (i.e., how variable those returns are) depends on the credit risk of the bond. Similarly, fixed performance fees for managing an investee’s assets are variable returns because they expose the investor to the performance risk of the investee. The amount of variability depends on the investee’s ability to generate sufficient income to pay the fee.
• B57. Examples of returns include:
  • Dividends, other distributions of economic benefits from an investee (e.g., interest from debt securities issued by the investee) and changes in the value of the investor’s investment in that investee.
  • Remuneration for servicing an investee’s assets or liabilities, fees and exposure to loss from providing credit or liquidity support, residual interests in the investee’s assets and liabilities on liquidation of that investee, tax benefits, and access to future liquidity that an investor has from its involvement with an investee.
  • Returns that are not available to other interest holders. For example, an investor might use its assets in combination with the assets of the investee, such as combining operating functions to achieve economies of scale, cost savings, sourcing scarce products, gaining access to proprietary knowledge or limiting some operations or assets, to enhance the value of the investor’s other assets.

Attention is also invited to the below basis for conclusion paragraphs to IFRS 10 (on which Ind AS 110 is based):

• BC39. The Board believes that reputational risk is part of an investor’s exposure to risks and rewards, albeit a risk that arises from non-contractual sources. For that reason, the Board concluded that when assessing control, reputational risk is a factor to consider along with other facts and circumstances. It 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.
• BC62.… ED 10 used the term ‘returns’ rather than ‘benefits’ because ‘benefits’ are often interpreted as implying only positive returns.
• BC63. The Board confirmed its intention to have a broad definition of ‘returns’ that would include synergistic returns as well as more direct returns, for example, dividends or changes in the value of an investment.
• BC64. Although some respondents to ED 10 commented that ‘returns’ could be interpreted narrowly to refer only to financial returns such as dividends, the Board believed that the broad description of returns included in the IFRS should ensure that the Board’s intention to have a broad definition is clear. The Board also confirmed that an investor’s returns could have the potential to be wholly positive, wholly negative or both positive and negative.

Considering the above, it may be noted that variable return under Ind AS 110 is a wide notion that also encompasses non-financial returns, such as, exposure to loss or expenses from providing funds, donation, credit or liquidity support and intangible benefits of reputation and image from good governance practices, synergistic returns that are not available to other interest holders, such as, combining operating functions to achieve economies of scale, impact on market capitalization, etc. Further, returns include not only positive returns, but negative returns as well.

Considering the above and specific facts outlined, one may make key arguments to states that the Company has exposure to variable returns arising from relevant activities of the NPE:

• The Company contributes funds for CSR/ welfare purposes and provides credit or liquidity support to the NPE, whose primary objective is to implement the CSR/ welfare activities. Thus, the NPE is apparently dependent on and carries out or manages CSR/ welfare activities on behalf of the Company. The Company involvement in these activities, along with the support it provides, further underscores its exposure to variable returns arising from the NPE activities.
• The Company has an exposure to variable returns in the form of exposure to statutory penalties for non-compliance with the Company’s CSR obligations, loss from funding or providing liquidity support for running the NPE. In addition, there are likely to be intangible/ non-financial returns by way of enhancement or damage to reputation and image.
• Paragraph B57(c) of Ind AS 110 states that an investor might use its assets, with the investee’s assets, to enhance the value of its other assets. From the Company’s perspective, this could include the intangible benefit of being associated with the NPE and providing it with a support function.

Therefore, it can be argued that the NPE engaged in CRS/ welfare activities of the Company has the ability to affect the Company’s returns.

How we see it

Variable return under Ind AS 110 is a wide notion which includes financial returns, such as exposure to loss or expenses from providing funds, intangible benefits of reputation and image from good governance practices. Further, under Ind AS 110, returns do not have to be generated within the investee. Rather, an investor could be exposed to the returns indirectly from its involvement with an investee.

4. Linkage between power and returns

Through power, the Company can affect how the NPE’s activities, are conducted and the resultant variable returns. Hence, this criterion for control evaluation will also be met.

Considering the above evaluation, it appears that the Company may have control over the NPE and need to consolidate financial statements of the NPE with its financial statements.

Practical challenge and perspective

As stated above, it is expected that based on Ind AS 110 evaluation, many companies may need to consolidate NPEs incorporated/ set-up by them or other NPEs where they are actively involved in operations and providing funding support. In such cases, practical challenges will arise as to how should the Company deal with the NPE’s profits and/ or equity while preparing consolidated financial statements (CFS). Should such amounts be added to the profits and equity at the CFS level? If yes, will those amounts be reflected as non-controlling interest (NCI)?

Assurance EYe

Ind AS does not directly deal with these issues. In our view, in the absence of specific guidance, one may need to evaluate based on the requirements of other Ind AS and overall GAAP framework. It may be noted that under Ind AS 110, a combination of like items of assets, liabilities, equity, income, expenses, and cash flows of the parent with those of its subsidiaries is one of many consolidation procedures. Overall, the Standard requires consolidated financial statements to be prepared as the financial statements of a single economic entity. Hence, there is a need to apply all Ind AS again at the CFS level. In applying these Ind AS at the CFS level, the Company will need to evaluate whether the group has a legal, contractual or constructive obligation to spend the amount represented by the equity and/ or profit of the NPE toward specified activities? If any such obligation exists, the group may need to provide for those obligations as per the requirements of applicable Ind AS, e.g., Ind AS 37 Provisions, Contingent Liabilities and Contingents Assets. Similarly, as per the requirements of Ind AS 7 Statement of Cash Flows, the group may need to evaluate whether cash and bank balances of the group can be presented as cash and cash equivalents of the group or they are in the nature of restricted/ other bank balances?

We believe that the above evaluation may require exercise of significant judgment and also, in the absence of specific guidance, it is possible that different entities adopt different views. We recommend that the Ministry of Corporate Affairs (MCA), the National Financial Reporting Authority (NFRA) or the Institute of Chartered Accountants of India (ICAI) should provide an appropriate clarification or guidance on how to deal with this situation. Till the time such guidance is provided, it is imperative that the companies consider substance of their transaction in evaluating various possible views. They should also discuss and agree view with their auditors upfront.

How we see it

The Companies are likely to face unique challenges in consolidation of NPEs. To ensure consistency in handling such situations, we suggest that regulators and/ or standard setters should provide an appropriate guidance.

Conclusion

With the release of the Opinion by the EAC of the ICAI, it has become further clear that the Companies need to consider NPEs or similar entities for consolidation under Ind AS. The fact that the Company does not get dividend or similar other financial return will no longer be a valid argument to justify non-consolidation. Companies that may not have considered consolidation in the past should re-evaluate their position and agree on the way forward with their auditors upfront. They should also assess and address any other implications of consolidation in advance.