Brief facts of the enquiry:

The Accounting Standards Board (the Board) received enquiries regarding:

A.Application of IFRS 10 requirements to a modaraba management company and modaraba; and

B.Preparation of consolidated financial statements by modaraba management company under the Companies Act, 2017.

Opinion:

The Board based on the enquired fact pattern discussed the following matters:

•Considering the typical structure of modaraba management companies in Pakistan, where these are required to hold 10% units of modarabas and charge management fees up to 10% of profits of modarabas (i.e. total stake of 20% in modaraba):

•Whether modaraba management companies fulfill the requirements of ‘control’ as given under IFRS 10?

•What should be the acceptable benchmark (i.e. 20% or more) when a modaraba management company assesses its control over a modaraba?

•If a modaraba management company meets the requirements of ‘control’ under IFRS 10:

•Can it be construed that the directives of the Companies Act override the requirements of IFRS 10 and treat a modaraba management company and modaraba as associates, only; and require modaraba management company and modaraba(s) to submit separate financial statements, and hence override the requirements of IFRS 10 for consolidation of modaraba and modaraba management company?

A.Application of IFRS 10 requirements to a modaraba management company and modaraba

Paragraph 6 of IFRS 10 states that “an investor controls an investee 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.”

The Board noted that in context of the submissions shared in the enquiry, under IFRS 10 a modaraba management company having control over a modaraba, would be required to prepare consolidated financial statements.

The Board noted that based on paragraph 7 of IFRS 10 a modaraba management company would have control of a modaraba if it has all the following elements:

(a)Power over the modaraba;

(b)Exposure, or rights, to variable returns from its involvement with the modaraba;and

(c)The ability to use its power over the modaraba to affect the amount of its returns.

The Board noted that the three elements are cumulative, therefore absence of any element fails the control assessment.

The Board also noted that, in general, two elements i.e., (a) power over the modaraba, and (b) exposure or rights to variable returns from its involvement with the modaraba, appear to be present between a modaraba management company and modaraba.

(a)Power over the modaraba:The Board noted that under the regulatory framework applicable to modarabas and modaraba management companies, the power to manage the affairs of a modaraba rests solely with the modaraba management company. The board of directors of modaraba company performing the governance role, approve all major decisions relating to operating and financial policies of modaraba. Further, the key management personnel of the modaraba is appointed by and accountable to the board of directors of the modaraba management company.

(b)Exposure, or rights, to variable returns from its involvement with the modaraba: The Board observed that under IFRS 10, variable returns are returns that are not fixed and have the potential to vary as a result of the performance of an investee.

With regards to a modaraba management company, in general, it obtains following returns in the capacity of a management company and investor.

Dividend: Modaraba management company is required to hold at least 10% of total modaraba certificates at all times. Accordingly, modaraba management company would earn dividend income at par with the other modaraba certificate holders.

Management fee: Modaraba management company is entitled to a remuneration for the management services rendered up to a maximum of 10% per annum of the net annual profits of the modaraba, under the statutory framework.

The management fee and dividend on investment of a modaraba management company are linked to performance and profit of modaraba, therefore are variable returns in accordance with IFRS 10.

(c)The ability to use its power over the modaraba to affect the amount of the modaraba management company’s returns: The third element of control (paragraph 17 of IFRS 10) is the link between power and returns. This is reflected by an investor’s ability to use its power over an investee to affect the amount of the investor’s returns. This involves assessing whether an investor acts as a principal or an agent.

The Board noted that in the enquired matter, the key factor would be modaraba management company’s ability to use its power over the modaraba to affect the amount of its returns (i.e. variability of returns).

Paragraph B60 of IFRS 10 explains that all of following factors are to be considered in assessing if an investor acts as a principal or an agent:

(a)the scope of the decision maker’s authority over the investee;

(b)the rights held by other parties, including substantive removal rights;

(c)the remuneration to which the decision maker is entitled; and

(d)the decision maker’s exposure to variability of returns from other interests it holds in the investee.

The factors consider the nature of the decision-maker’s rights and its incentives to act primarily on its own behalf or on behalf of others.

In terms of IFRS 10, two of the above factors are determinative regardless of other indicators; (a) a single party holds substantive kick-out rights; (b) the decision maker’s remuneration is not commensurate with the services provided. While judgment is required in assessing the other factors for determination of relationship between modaraba management company and modaraba.

In the context of modaraba management company and its relationship with modaraba, the Board observed that:

(a)The scope of the decision maker’s authority over the investee: The modaraba management company has decision-making authority and the ability to undertake the relevant activities of the modaraba within the regulatory parameters. The affairs of the modaraba are governed by the board of directors of the modaraba management company.

(b)the rights held by other parties, including substantive removal rights: The modaraba certificate holders do not hold any substantive rights to remove the modaraba management company. The modaraba certificate holders can redeem their certificates within particular limits set by the governing documents of modaraba. The modaraba certificate holders also do not have the power to modify the investment/lending mandate or windup the modaraba.

(c)the remuneration to which the decision maker is entitled: Modaraba management company is entitled to a fee for management of modaraba (up to a maximum of 10% of the modarabas annual net profit), and is considered to be commensurate with the level of services.

(d)the decision maker’s exposure to variability of returns from other interests it holds in the investee: The existence of this factor would depend on the particular facts and circumstances of each modaraba management company.

The Board while analyzing the exposure to variability of returns, in context of the enquired fact pattern noted that investment of 10% along with a 10% management fee exposes the modaraba management company to 20% variable return (i.e. economic interest).

The Board noted that:

Although paragraphs B72 of IFRS 10 note that a greater magnitude of economic interest is associated with a greater likelihood of the investor acting as a principal. However, IFRS 10 through paragraphs BC141 and BC142 makes it clear that for determination of principal/ agent no quantitative threshold of variability of returns exists.

IFRS 10 also contains Application Guidance, and the examples 13 to 15 of this guidance indicate that the decision-maker needs to consider all relevant factors to determine control.

IFRS 10 does not specify any quantitative benchmarks/thresholds (i.e. percentages of economic interest) that are conclusive evidence for determining control of an investee. However, IFRS 10 through Application Examples at least indicate to the IASB’s thinking, possibly narrowing the range for level of aggregate economic interest in which judgement about significance of exposure to variability of returns has to be made.

In the application example 14A of IFRS 10, an investor despite extensive decision-making authority to direct relevant activities of the fund, but with exposure to 22% variability of economic interest is considered to be an agent. In context of the enquired matter, modaraba management company’s aggregate variable economic interest of 20% is below 22%. As per the guidance provided in IFRS 10 (through Application Examples), this exposure to variability of economic interest indicates that the modaraba management company is an agent.

On the other hand, IFRS 10 in the Application Example 14B, explains that an investor having 37% variable economic interest is considered a principal (the 37% variable return is based on 20% direct investment, 1% fee, and 20% of profits if a specified profit level is achieved). Example 14B also notes that “having considered its remuneration and the other factors, the fund manager might consider a 20% investment to be sufficient to conclude that it controls the fund. However, in different circumstances (i.e. if the remuneration or other factors are different), control may arise when level of investment is different.”

The Board also observed that under the statutory provisions, 10% investment by a modaraba management company in the modaraba is the minimum level of investment. A modaraba management company with higher level of investment in the modaraba, could be a principal, based on the principle outlined in IFRS 10. The relevant facts and circumstances of each case must be carefully considered, to conclude on whether a modaraba management company’s exposure to variability of returns is of significance leading to establishment of principal relationship with the modaraba.

The Board, based on the information provided in the enquiry and above discussion, concluded that:

(a)IFRS 10 provides three elements of control and absence of any element fails the control assessment.

(b)IFRS 10 does not specify any quantitative benchmarks/thresholds (i.e. percentages of economic interest and variability) that are conclusive evidence for determining control of an investee. The decision-maker needs to consider all relevant factors to determine control.

(c)Based on guidance provided in the IFRS 10 and more specifically the Application Examples 14A and 14B, a modaraba management company’s 10% investment in modaraba and 10% management fee do not appear to create exposure to variability of returns of such significance to conclude that it controls the modaraba.

Modaraba management companies with higher level of investments in modarabas (more than minimum 10% investment in modaraba) or other interests, would have higher exposure to variability of returns. In such cases, the variability of returns and other factors, could result in establishing control of a modaraba.

B.Preparation of consolidated financial statements by modaraba management company under the Companies Act

The Board noted that differing views could exist on the requirement to prepare consolidated financial statements by a modaraba management company under the Companies Act.

IFRS 10 adopted by SECP, determines whether an investor is required to consolidate an interest in an investee. IFRS 10 is part of the financial reporting framework applicable to a modaraba management company. While, the Companies Act also specifies financial reporting requirements for the preparation of consolidated financial statements. Further, the Companies Act also contains a specific section related to the financial statements of modarabas and modaraba management companies.

The Board also observed that it is well understood that the provisions of Companies Act and other statutory laws that are applicable to modaraba management company and modaraba override the requirements of IFRS.

In context of the enquired matter, the divergent views primarily originate from varied understanding of the definitions and statutory requirements of the Companies Act. Therefore, the enquired matter is primarily a legal matter rather than an accounting matter.

The requirement to prepare consolidated financial statements by a modaraba management company (under the Companies Act) in essence results from differences between IFRS and the Companies Act. The Companies Act and IFRS have different definitions/concept of ‘Associated companies/undertakings’, ‘Holding company’ and ‘Subsidiary’, and criteria for determination of control.

The Board observed that the financial reporting framework should guide and determine the applicability of accounting principles and basis of preparation of financial statements for companies/entities. Based on this principle, the requirements and guidance contained in IFRS 10 should be followed for determination of control and preparation of consolidated financial statements. This approach would eliminate the departures from IFRS requirements and would also ensure common understanding and application of financial reporting provisions.

Application of IFRS with additional disclosures, when necessary, is presumed to result in financial statements that achieve fair presentation.

Accordingly, the Board concluded that:

(a)IFRS 10 is a part of the financial reporting framework applicable to modaraba management company. However, specific provisions/directives of statutory law override the requirements of the applicable financial reporting framework.

(b)In principle, the applicable financial reporting framework should determine the application of accounting principles and basis of preparation of financial statements of entities. This approach would eliminate the departures from IFRS and would also ensure common understanding and application of financial reporting provisions. Based on this principle-based approach, the requirements and guidance contained in IFRS 10 should be followed.

(c)In view of the provisions of the Companies Act, the requirement to prepare consolidated financial statements by a modaraba management company is primarily a legal matter rather than an accounting matter. Varied understanding and differing views on the enquired matter can be eliminated by following the above principle-based approach to financial reporting.

(Issued in September, 2020)